Overview
Funds From Operations (FFO) is a measure used by Real Estate Investment Trusts (REITs) to assess the amount of cash generated from their operations. This metric begins with net income, as derived using Generally Accepted Accounting Principles (GAAP). To this net income, it adds back depreciation deductions and deductions for amortization of deferred charges, as these are non-cash expenses that do not impact the actual cash flow of the REIT.
Key Components
- Net Income: The company’s total profit as reported using GAAP.
- Depreciation: The reduction in value of the REIT’s property over time, a non-cash expense added back to net income.
- Amortization: The gradual write-off of deferred charges, another non-cash deduction added back to net income.
- Exclusions: FFO excludes extraordinary items and gains or losses on the sale of real estate, as these are not indicative of the REIT’s core operating performance.
Examples of FFO Calculation
-
Example 1: A REIT reports $1,000,000 in net income. The REIT has $200,000 in depreciation expenses and $50,000 in amortization of deferred charges. FFO would be calculated as follows:
\[ \text{FFO} = \text{Net Income} + \text{Depreciation} + \text{Amortization} \ \text{FFO} = $1,000,000 + $200,000 + $50,000 = $1,250,000 \]
-
Example 2: Another REIT reports $800,000 in net income. It has $100,000 in depreciation expenses, $20,000 in amortization, and a $30,000 gain on the sale of real estate. Since gains on sales are excluded:
\[ \text{FFO} = \text{Net Income} + \text{Depreciation} + \text{Amortization} \ \text{FFO} = $800,000 + $100,000 + $20,000 = $920,000 \]
Frequently Asked Questions
What is the importance of FFO?
FFO is a crucial measure for evaluating the cash-generating performance of a REIT. It helps investors understand the company’s operational efficiency without the distortions of noncash expenditures and atypical gains or losses.
How does FFO differ from net income?
Net income includes noncash expenses such as depreciation and amortization as well as extraordinary gains or losses. FFO adjusts net income by adding back noncash expenses and excluding gains or losses on sales of properties, providing a clearer view of the ongoing cash-generating capability.
Why are depreciation and amortization added back to net income in FFO?
Depreciation and amortization are noncash charges; they reduce reported net income but do not affect the cash available for distribution to investors. Adding them back provides a better understanding of the cash flow available to the REIT.
What are extraordinary items and why are they excluded?
Extraordinary items are unusual, infrequent, and non-recurring events that can significantly skew earnings. Excluding them ensures FFO reflects the core operational performance of the REIT.
Related Terms
- Real Estate Investment Trust (REIT): A company that owns, operates, or finances income-producing real estate.
- Generally Accepted Accounting Principles (GAAP): Standard framework of guidelines for financial accounting.
- Amortization: The gradual write-off of the initial cost of an asset over a period.
- Depreciation: The loss of value of an asset over time due to use, wear and tear, or obsolescence.
Online References
- Investopedia: Funds From Operations (FFO)
- National Association of Real Estate Investment Trusts (Nareit)
Suggested Books for Further Studies
- “Investing in REITs: Real Estate Investment Trusts” by Ralph L. Block
- “Real Estate Investment Trusts: Structure, Analysis, and Strategy” by Richard Garrigan and John Parsons
Fundamentals of Funds From Operations (FFO): Real Estate Basics Quiz
Thank you for exploring Funds From Operations (FFO) with us. Keep expanding your knowledge on real estate financials for a solid foundation in investment strategies!
